13 1 Motivation and Scope
3. Overview of the papers
3.1 Exploration economics in a regulated petroleum province
Oil and gas exploration has been subject to economic research for decades. The attention has largely been concentrated on the US oil and gas industry, with some studies also for the United Kingdom. In this article, we present new insights on the relation between exploration activities and economic variables in the highly regulated industrial environment in Norway.
Starting with the Ekofisk discovery in 1969, a number of subsequent field developments laid the foundations for a new and important industry in Norway, and a significant supplying region for US and European oil and gas markets. The Norwegian government has played an active role in the development of a Norwegian petroleum industry, with a strategy characterised by gradualism. The impact of external market forces has traditionally been subdued by a carefully developed regulatory system, followed up by well- developed institutions and governance systems.
Based on detailed database information from the Norwegian Petroleum Directorate, a unique data set has been developed to cover the 40-year history of three separate regions of the Norwegian Continental Shelf (NCS). This panel data set has not been subject to econometric studies before. A drilling function is derived from a simple theory of exploration, whereby drilling efforts are explained by the oil price, cumulative discoveries and available exploration acreage. We estimate error-correction models that capture sluggishness and short-term dynamics in the data, as well as the longer-term
relations between drilling efforts and the explanatory variables. Finally, we present projections to illustrate how exploration activity is affected by changes in oil prices, licensed exploration acreage and new discoveries. Our models are estimated for a regulated market regime, and the results reveal new and interesting insights with respect to exploration behaviour. We establish economic effects that are quite robust, but their magnitude is rather small compared to previous studies. The estimated model suggests a robust, long-term impact from the oil price, whereas the estimated short- term effects are rather weak. Our results illustrate how new licensing rounds stimulate exploration drilling in new attractive prospects. Discoveries are also shown to provide additional feedback to exploration drilling, but this drilling response quickly culminates in anticipation of new licensing rounds. Our models are quite successful in accounting for dynamics and sluggishness in the exploration drilling behaviour, and the estimated error-correction models suggest a rapid adjustment process.
3.2 Efforts and efficiency in oil exploration: a VEC approach
Drilling efforts have been subject to a wide range of econometric studies since the mid 1960s, especially for the US. Less attention has been paid to the success and efficiency of oil and gas exploration, not to mention the interaction between efforts and efficiency. Only a few empirical exploration studies cover more than one oil price cycle. Modern techniques of time series econometrics are also yet to be applied to oil and gas exploration data. Finally, the data we observe for efforts and efficiency in oil exploration are produced by simultaneous decisions in each company. This simultaneity should be appreciated also in econometric models of the exploration process. To bridge these gaps in the economic literature, this study examines three components of reserve growth simultaneously in an integrated and novel modelling approach. A theoretical model for reserve-generation is derived from standard neoclassical behavioural assumptions. A decomposition of reserve growth is then applied to specify annual reserve additions as a result of drilling activity, success rates and average discovery size. Co-integration techniques are applied to estimate a vector error-correction model with three simultaneous equations for drilling activity, success rates and average discovery size. The econometric model also links the three components of reserve-generation to relevant economic, geological and technology variables.
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The data set covers the full history of oil and gas activity on the Norwegian Continental Shelf (1969-2004). The estimated model gives a breakdown of effects from explanatory variables between these key components of reserve- generation, as well as a systematic separation between short-term (temporary) effects and long-term (persistent) effects in the exploration process. Estimated long-term elasticities are illustrated in Figure 9.
Figure 9. Decomposed elasticities of reserve generation
Estimated partial and total elasticities by explanatory variable (per cent) *)
-1.5 -1.0 -0.5 0.0 0.5 1.0 1.5
Average discovery size Drilling success Drilling efforts 0.89
0.05
-1.29a)
Oil price Licensed acreage Seismic surveys Depletion
0.44
*)
FIML estimates obtained with Stata 9.0 (see Chapter 3).
a)
Semi-elasticity: percentage change in dependent variable from absolute change in depletion indicator.
An increase in the oil price of 1 per cent produces a persistent increase in annual reserve-generation of 0.89 per cent, according to our results. More precisely, a negative influence from the oil price on the discovery rate is dominated by a positive influence on average discovery size. On impact, this suggests a pro-cyclical pattern for reserve-growth. The proposed modelling approach illustrates that policy measures need not and should not be limited to the regulation of drilling activity. With reserve additions as the ultimate target, the potential gains from measures to stimulate the success rate or average field size may well exceed the direct importance of drilling activity in itself (i. e. number of spudded wells). Second, our results suggest that annual reserve additions are procyclical, due to the strong positive link between the oil price and average discovery size. If the government interest is to stabilize reserve growth over time, this result provides a case for countercyclical licensing policies.
3.3 Investment and uncertainty in the international oil and gas industry
Standard theory of irreversible investment and real waiting options suggest that the relationship between investment and uncertainty is negative. However, recent contributions to the theory of strategic investment point out that investment imply not only the sacrifice of a waiting option, but also a potential reward from the acquisition of future development options. Increased uncertainty has the potential to increase the value of both these types of real options. Thus, the theory of compound options may give rise to a positive relationship between investment and uncertainty. Empirical studies are therefore required to settle the question. With highly strategic investments and an abundance of real options, the oil and gas industry offers an especially appropriate application.
The combination of investment theory, modern econometric procedures and panel data offers a robust framework to study the impact of industry uncertainty on total investment expenditures. Applying System GMM estimators on a data set covering 170 companies over the period 1992-2005, we draw on recent empirical research of the relation between investment and uncertainty in manufacturing industries. However, our scope is different, and so are our results.
Our results suggest that industry-specific uncertainty (oil price volatility) has a stimulating effect on investment rates, as suggested by modern theory of strategic investment and real options. On the other hand, overall uncertainty (stock market volatility) represents a bottle-neck for investment and capital formation. A negative relationship between investment and uncertainty is the standard result of modern theories of irreversible investment. The majority of empirical studies in the field are also in support of this hypothesis. Based on recent contributions to the theoretical investment literature, our results offer a valuable supplement, as we offer empirical support to the idea that strategic investments with real options may give rise to a positive investment/ uncertainty relationship.
Over the last 15 years, international oil and gas companies have gone through a period of industry upheaval, restructuring and escalating market turbulence. Easily accessible oil and gas reserves in market-oriented economies like USA, Canada and United Kingdom are faced with depletion. Oil and gas investments are now gradually redirected in a rat race for increasingly scarce oil and gas resources. Our results should therefore be interpreted in the context of strategic investments (Bartolini, 1993; Smit and Trigeorgis, 2004).
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3.4 Shifting sentiments in company investment
Recent developments in the oil and gas industry suggest that investment behaviour is not necessarily stable over time. Changes and shocks in prices, liquidity and uncertainty may carry over to management mentality. Moreover, substantial shifts in the economic environment of the firm may also induce changes in the underlying models of investment behaviour, among managers as well as investors. We propose a micro-econometric framework to assess how the process of capital formation at the firm-level might be affected by a period of far-reaching industrial upheaval and restructuring.
Based on accounting information for 253 companies over the period 1992- 2005, we specify the process of capital formation as an accelerator model with error-correction, whereby investment is explained as a continuous adjustment process towards a long-term equilibrium relation between capital and output. The error-correction process is disturbed by temporary shocks, and by variation in a set of financial and operational control variables. Based on the industrial restructuring of the late 1990s, we apply a flexible dummy-variable (GMM) procedure to test for the presence of a structural break in oil and gas company investment.
Our results provide robust evidence for two historical regimes of investment behaviour in the international oil and gas industry over the last 15 years; one from 1992 to 1997, and one from 1998-2005. The late rise in oil price and cash-flows has had a far smaller impact on investment rates than what was typical before 1998, suggesting that financial market pressures in the aftermath of the Asian economic crisis have caused tightened capital discipline in recent years. Moreover, the early 1990s were characterised by a negative relationship between investment and uncertainty, whereas the recent increase in oil price volatility has spurred investment over the last few years. This result is at odds with the vast majority of previous studies of investment and uncertainty, but well in line with recent development of theories of compound options structures, imperfect competition and strategic investment behaviour (e.g., Smit and Trigeorgis, 2004).
Industrial leaders and their companies respond continuously to changing political and market environments.
Their models and ways of thinking
may be stable for periods. However, f
rom time to time their mindset is also challenged by external forces, and sometimes these pressures bring about deeper behavioural changes. Our study demonstrates that such a change tookplace in the oil and gas industry in the 1ate 1990s, in response to external economic shocks and massive pressure from financial markets.
3.5 Financial market pressures, tacit collusion and oil price formation
Ever since the oil price shocks of the early 1970s, the Organisation of Petroleum Exporting Countries (OPEC) has been followed with massive interest from the public, reflecting the vital significance of the oil price to industry, households and financial markets. The special structure of the oil market has also attracted scholarly interest, with numerous studies of OPEC’s role and strategy in various models of producer behaviour under imperfect competition. Less attention has been given to the role of producer behaviour in non-OPEC countries. Nevertheless, investment behaviour in the international oil and gas industry is an important part of supply-side dynamics in the oil market, and therefore also an important factor behind the formation of oil prices.
Figure 10. Company valuation and oil market shares
RoACE and EV/DACF 2003
2 4 6 8 10 12 5 10 15 20 25 Hydro Hess Conoco Phillips Marathon Repsol Eni Occidental Statoil PetroCanada BP Shell Chevron Total Exxon "Buy" "Sell" RoACE (%)
EV/DACF Oil market shares1970-2005, per cent
0 20 40 60 80 100 1970 1977 1984 1991 1998 2005 Non-OPEC OPEC
Source: Deutsche Bank (2004), US Energy Information Administration (EIA).
The key hypothesis of this paper is that a strategic redirection of the international oil industry towards the end of the 1990s has had long-lived effects on OPEC strategies – and on oil price formation. Starting in 1998, increased focus on shareholder returns, capital discipline and return on capital employed (RoACE) caused a slowdown in investment rates and production growth among international oil companies. Thus, the emphasis on short-term profitability and financial indicators had the same effect as a coordinated
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equilibrium of reduced investment, implicitly representing a tacit collusion to support an increase in the oil price. At the same time, strong growth in oil demand and consolidation in the competitive fringe allowed OPEC to raise their price ambitions significantly at the turn of the century.
The objective of this study is to quantify the oil price impact of these developments. Using an equilibrium model for the global oil market, we examine the effects of the change in investment pattern on oil supply and oil prices, as compared with a situation characterised by industrial stability and unchanged price ambitions within OPEC. The model simulations clearly suggest that enhanced capital discipline caused a temporary slowdown in investment and production growth among international oil companies. Consequently, global exploration activities, investment expenditures and oil production growth were suppressed, allowing OPEC to raise their price ambitions. Our results suggest that even temporary economic and financial shocks may have a long-term impact on oil price formation. Specifically, we find that the curb on IOC investments in the late 1990s caused an increase in the oil price of 10 per cent in the long run. Both OPEC and non-OPEC producers gain from this development, whereas the cost is carried by oil- importers and consumers.
3.6 Valuation of international oil companies
Since the late 1990s, stock market analysts have focused strongly on short- term accounting return measures, like RoACE, for benchmarking and valuation of international oil and gas companies. To assess important drivers of company valuation, a simple econometric model is specified and estimated on market and accounting data for 14 major oil and gas companies from 1990 to 2003. The company-specific valuation multiple EV/DACF is regressed against a number of financial indicators, as well as the oil price. Our models take into account the potential endogeneity challenge in our data for market valuation and company performance.
A key result is that the general perception of RoACE as an important value- driver is not supported by our estimated model. More precisely, the econometric results indicate that the valuation impact of this simple profitability measure is negligible. On the other hand, valuation multiples respond negatively to an increase in the oil price, implying that oil and gas companies are priced at mid-cycle oil prices. The estimated model also suggests a robust and material influence on market valuations from oil and gas
production. This suggests that company size and reputation still plays an important role in the valuation process. Finally, reserve replacement ratios contribute positively to stock market valuation, but the effect is quite modest, and the significance is marginal.
The study elucidates some of the weaknesses of RoACE for company valuation purposes. Our primary focus is on inter-company comparisons and relative stock market valuation. However, within the individual companies, a consistently normalized RoACE may still be a useful key indicator in their internal efforts to improve operational and financial performance over time. This paper represents an early attempt to substantiate the links between market valuation and financial and operational indicators in the international oil and gas industry. The results are interesting, but preliminary. Our belief is that profitability and returns on invested capital is linked to company valuations. However, our RoACE variable does not establish this link. Future research should explore alternative measures of underlying financial performance, to overcome the weaknesses of RoACE.